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Cadillac Tax, Redux

February 8, 2010 at 4:00 am

Austin Frakt

Let’s revisit the Cadillac tax using the results presented in my two prior posts on the employer based health insurance tax subsidy. In my first post I showed that the tax subsidy for an individual with a federal marginal income tax rate of 20% and a state marginal income tax rate of 5% is 37%. That is, for each dollar paid by the employer for health insurance instead of wages, government (federal and state) lose 37 cents. That’s the tax subsidy.

Then, in my second post I explained, with the help of Gruber and Lettau, that health spending increases by 0.7% for each 1% drop in cost of insurance (that’s the -0.7 elasticity on the intensive margin I described). Putting that together with the 37% tax subsidy, we find that health spending by Americans with employer-based insurance is higher by 26% (=37% x 0.7) than it would be without the tax subsidy. Note that this assumes an average federal marginal tax rate of 20% which, if anything, is a bit low.

Let that sink in for a minute. Health care expenditure by workers and their families with employer based insurance is 26% higher due to the tax subsidy (a follow-up post attempts to convert this to an annual dollar figure). That’s huge! If we could beat that back, we’d make a substantial dent in the degree to which we overspend (relative to other OECD countries) on health care. And that’s precisely what the Cadillac attempts to do, in its special and blunt way.

Now, I’m not a fan of the precise structure of the Cadillac tax. It could be improved in many ways, e.g. adjusted for geographic variation in health care costs and risk profile of workers. Another thing I’d like to see is that it be made more progressive by setting it to be the actual worker-specific tax subsidy rate rather than a flat 40%. But to do that would require imposing the tax directly on workers instead of on insurance companies. Since workers will ultimately pay the tax either way, the politically expedient ruse that insurers are the ones being taxed actually prevents the Cadillac tax from being more sensibly designed. That’s a shame.

So, if you don’t like the Cadillac tax because it is crude and imprecise, I’m with you. But the basic idea of ratcheting back the tax subsidy is sound on economics grounds. I just wish we could do it better, though I also understand there are political obstacles to a sound design. The Cadillac tax is an attempt at a solution to both a policy problem and a political one. Unfortunately, it solves neither perfectly. Few products of the legislative process do.

I agree, if I read this correctly. It idea of ratcheting back the tax exclusion is sound, but the specific proposal is not.

My problem is not with using an excise tax as a surrogate for a direct attack on the tax exclusion. I just think a cap on benefits is messy, requiring all sorts of adjustments for things like age, risk size and composition of employer pool, and on and on. This makes the alternative proposal, to base the cap on income level, look rather attractive.

So something like a 20% excise tax on all benefits that begins to phase in at some high income level sounds more attractive to me. I don’t really care at what specific level, so long as it’s above the income cap for Social Security payroll tax. This way combined marginal tax rates can be held to a reasonable value.

Sorry, that should have been “age (comma) risk (comma) size and composition of employer pool…”

Also, my rationale for the 20% excise tax was that if the tax incentive is reduced, is should be possible to reduce incentives to over-consume without needing a Congressional committee to make decisions about what level of spending is appropriate for each specific circumstance.

@Bart – We agree. The problem is that the improved version we favor seems not to be politically viable. So, we’ll likely get a crappy version, with a few tweaks that make it marginally less crappy. I think that’s better than nothing, particularly when the revenue has to come from somewhere and other avenues are blocked. I hope that the reform gets re-reformed in the future, maybe even before much of it bites, to work out some of these kinks. But if the first reform doesn’t pass we won’t see anything like it for a long time. And that’s how I end up backing something that isn’t as perfect as I’d like.